Apple Reverse Convertibles: How Brokerage Firms Pervert Everything

“Mahaney joined the gang of Italian Dave, the famed sneak thief and fagin, whose group of street urchins and pickpockets were among the notorious thieves of the Five Points. Italian Dave had between 30-40 youths, between the ages of 9 and 15, whom he housed in a Paradise Square tenement building. It was here that Mahaney was trained to steal along with Italian Dave’s other pupils.Practicing on dummies dressed as men and women, Mahaney and the others learned how to pickpocket and snatch valuables such as purses and muffs. They were also instructed on begging and stealing from store windows and counters. Whenever a student was clumsy or otherwise displeased Italian Dave, their leader, dressed in a policeman’s uniform, would hit them with a nightstick.

Mahaney was very successful in this trade and, becoming a noted pickpocket and sneak thief in his own right, was personally taken under the wing of Italian Dave and made his protégé. He was also allowed privileges given to few others including going on marauding expeditions where he and Italian Dave would roll a drunk or snatch a purse.”

from Herbert Asbury’s ‘The Gangs of New York’

Prior to the Facebook IPO, when everyone was freaking out with excitement, I had warned repeatedly against individual investors buying into so-called Facebook and Twitter funds from brokers. I’ve been told by several potential investors that my admonition saved them from getting stuck in these locked up, high cost scams designed to take advantage of the ignorant and the inexperienced. I’ve even spoken to a former broker who left the industry after watching his colleagues plug people with this stuff (See “Facebook Funds: The Biggest Scam Running” for more).

I talk about private funds and private placements in my book in a now-infamous chapter called “Murder Holes”. Alongside the privates, I go after reverse convertibles and all other retail-market structured products, which I think are pure evil.

This weekend Jason Zweig sheds light on some astonishing facts about how brokers also perverted the excitement around Apple to sell hundreds of millions of dollars worth of equity-linked reverse convertibles…

From the Wall Street Journal:

Imagine your broker says you just bought Apple stock for more than $700 a share, even though this week’s collapse drove the price below $440.

Now imagine being told you got this bum deal through the back door by purchasing debt issued by an entirely different company, probably your broker’s securities firm.

For many investors, this isn’t a bizarre fantasy. It has begun to happen in complex investments known as “equity-linked structured products” tied to the price of Apple shares. Investors who had fat yields on seemingly safe short-term debt soon will find out they have been handed huge losses, while the firms that sold them have profited.

firms such as J.P. Morgan Chase, Morgan Stanley, UBS and Barclays sold more than $722 million of these instruments, according to an analysis of Securities and Exchange Commission filings for The Wall Street Journal by Securities Litigation and Consulting Group, a financial-research firm in Fairfax, Va.

Last year, at least 450 new structured products were linked to Apple, according to SLCG. Three-quarters of them were issued when the stock was at least $550. The shares closed Friday at $439.88, down $60 for the week.

As a result, the value of Apple-linked products suffered a one-week drop of more than 15%, estimates Craig McCann, founder of SLCG. “The vast majority of them are now underwater,” he says.

Many investors will get far less than they expected. Losses exceed 25% on more than 100 of last year’s Apple-related products, SLCG estimates.

These were essentially unrelated derivative bets based on how Apple shares traded in a given window of time. Apple has nothing to do with it – Reverse convertibles are a sort of extra-chromosome inbred bond-like option contract, built to confuse and backed by the full faith and credit of the issuing bank. The disclosure language on these things is worthy of a Monty Python sketch and the way in which they’re sold by brokers, often themselves befuddled, is astonishing.

First, here’s how it works:

The typical equity-linked reverse convertible is a time-limited bet on a stock remaining between such and such levels. If the stock runs away higher, you got a handful of interest payments and your principal back with none of the upside. If the stock stays flat, you got the same minus the regret over missing any capital appreciation from not just owning the common shares. And if the stock drops below a certain threshold, you don’t get your cash back, you are paid in the form of stock held at a loss and issued at wherever the shares are trading at the contract’s maturity.

Now you might be asking yourself, why would any investors in their right mind want to be involved in a bet like that? And the answer is simple – they don’t, but their brokers pitch it to them and they think it has something to do with Apple (or any other stock) and they are told it’s “like a bond” so they think it’s safe. And to get off the phone they say yes. The way you know that nobody really wants these things unless they’re aggressively pitched them is there’s no real secondary market and the online brokerages don’t market them.

Because they are fucking toxic and only exist for the underwriters and brokers to take selling concessions and commissions, rolling them over and over again until one blows up. The same way brokers got their clients to buy into pre-IPO Facebook funds is the same way they sold this shit linked to Apple – taking advantage of the public’s irrational enthusiasm with a honeypot death trap.

The bottom line, anywhere there is enthusiasm about any type of investing idea, there is a brokerage firm already hard at work perverting this excitement to their own dark purposes. The internal discussion is never about whether or not the “customers” should be sold to, only about what can be gotten away with safely. And then the urchins are sent out into the streets to roll the drunks and rip purses and pocketbooks off the mesmerized crowd.

Don’t email me about how private placements and reverse convertibles for retail investors work fine if they’re used correctly. I’m not interested in being a sounding board for your self-rationalizations and/or biased defense of the business you’re in.

I’ve already met the foreman and the shop steward of the Rape Factory, took the tour and visited the gift shop. Trust me, I know all I need to about this stuff.